May 27, 2020

Debt Mutual Funds – Truths Mutual Fund Companies did not tell you

Many of us investing in Debt Mutual funds thinking they are safe. However, the recent events made us to relook into debt mutual funds by definition itself.

Debt Mutual Funds

As you may be aware, now debt funds turned to be riskier than equity funds. Because in the case of equity funds, even if the market fall, then there is a hope that in future the market will up and we may get a decent return. However, in case of debt mutual funds, in many cases it’s turning as a permanent loss to investors.

Debt Mutual Funds – Truths Mutual Fund Companies did not tell you

Now let us understand the certain truths which neither Mutual Fund Companies will nor the SEBI forced them to tell you (the investors).

# Debt Mutual Funds definition of SEBI is silent on CREDIT or DEFAULT RISK

If you look at SEBI’s definition of Debt Mutual Funds, it only states the Macaulay duration of the portfolio. It is not specifying the quality of the underlying securities the fund manager must hold with respect to each category of the fund (except Credit Risk Fund).

We all feel Liquid Funds are safe and best for the short term right? At the same time, long duration bond funds are risky. But in both cases, SEBI’s definition of funds is silent on CREDIT QUALITY.

The definition of Liquid Fund is “Investment in Debt and money market securities with maturity of upto 91 days only”.

The dinition of Long Duration Fund is “Investment in Debt & Money Market Instruments such that the Macaulay duration of the portfolio is greater than 7 years”.

If you notice the definitions, it is clear that SEBI simply classifying the funds based on the duration but not based on the quality of the securities.

Hence, fund managers have the freedom to choose the quality of the papers as per their wish to generate certain alpha over the index or peers.

This is what exactly happened with Franklin fiasco. This particular AMC invested in high risky low rated bonds whether it is Ultra Short Term or Short Term just managing the definition as per the SEBI.

We by definition going and investing thinking that Liquid Funds are safest and ultra short term, short term or long term funds are riskier. However, the fund manager has the same freedom to choose low rated paper (of course just to match the maturity) whether it is in Liquid Funds or Long Term Bond Funds.

Suppose a fund is claiming to be they are investing ONLY in high rated securities or Govt securities, it is based on their choice but not due to regulatory requirement. Hence, we need regulations in debt funds where the regulator is clear with respect to each category of the fund and how much risk the fund manager can take with respect to the quality of the papers.

# Generic definition of DURATION

If you again look at the definitions of the same two categories of debt funds which I explained above, you noticed that SEBI defining the funds based on Macaulay duration. How many debt fund investors understand this?

Macaulay duration – It is the weighted AVERAGE MATURITY of the cash flows from the bond.

If you really want to know in detail about Maculary duration, then refer the below video.

But do remember that it is AVERAGE. Hence, if we remember the quote from the famous book “Unveiling the Retirement Myth”, it is AVERAGE IS NOT APPLICABLE TO INDIVIDUALS.

This is what the Franklin also did. If you look at Franklin Templeton India’s disclosure with respect to their closed 6 funds and approximate timeline of when you will get back the money, then you can clearly see it.

Let us take an example of the Ultra Short Term Debt Fund. As per SEBI, the definition of Ultra Short Term Debt Fund is “Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between
3 months – 6 months”. But you look at the timeline of cash flow they receive from Franklin Templeton Ultra Short Fund is entirely different.

Especially look at what they are defining with respect to Macaulay Duration of Ultra Short Bond Fund. I will share the same for your benefit.

Q-If the Macaulay Duration of Ultra Short Bond Fund is only 4.53 months, why will it take you nearly 2 years to return a substantial percentage of the money in this fund?
A3: The Macaulay Duration reflects the average duration of the bonds held in the portfolio basis the expected cash flows of the bond. A portfolio will typically have an average maturity that is slightly longer than the Macaulay Duration. Hence, for example, in Ultra Short Bond Fund, a Macaulay Duration of 4.53 months means the portfolio has an average maturity of 5.27 months. This indicates, in very broad terms, that this is the mid-point of the maturity dates for the bonds held in the portfolio, not the date for the last maturity in the portfolio. Accordingly, you will see that with a Macaulay Duration of 4.53 months, the fund should be able to return around 50% in year 1 and substantial money in 2 years.
Also, for securities with interest rate reset at periodical intervals which have a floor and cap rate as per the terms of the issuance, the maturity date has been considered for the cash flow projections vis-à-vis the interest reset date which is normally considered in Macaulay duration and valuation by the valuation agencies. Further, this cash flow is after taking into account the fact that initial cash flows received will go towards paying the borrowing in the fund, which delays how soon the schemes can start to return monies to unitholders. It may also be noted that these calculations are on a conservative basis and do not consider any sale or prepayments or coupon payment. It will be the endeavor of the schemes to accelerate these payments through actively seeking pre-payments and opportunities to sell in the market while preserving value for unitholders.

Many retail investors in the wrong notion that if you are investing in Ultra Short Term Debt Funds means the fund manager will receive all his money back within 3-6 months as the definition also specify the same as per SEBI.

But the reality is entirely different. Don’t think that this is the case of with Franklin Templeton India Funds. It is the reality with respect to all AMCs and all debt funds.

This is the reason YOU MUST NOT ALIGN YOUR DURATION WITH THE FUND DURATION OF PORTFOLIO. Many of us invest in Ultra Short Term Debt Funds thinking it is meant for SHORT TERM. In reality the picture may be entirely different.

Conclusion:-These are the two biggest truths which many retail investors and in fact the adviser fraternity unaware of. We blindly invest and bear the pain at a later stage. Be cautious while investing in debt funds like how you be more cautious with equity funds (in fact you must be more cautious).

Refer our latest posts:-

6 Comments

  1. Very good and informative article. Particularly for retail investors like me. What are the alternate options of putting hard earned money in some good liquid or debt funds for coming 2 to 3 years? Can you name a few ?

    Reply
    • Dear Amit,
      If your requirement is within 3 years, then use Bank FDs.

      Reply
  2. Dear Sir,
    Thanks for the update.
    But what is option with retail investor apart from EPF, PPF, etc to invest in debt investment. These are again long term.
    Bank FDs and RDs are tax-inefficient.

    All money can not be put in equity funds. If I have some short term target of buying house in 4-5 yr time frame, I have to keep some money in debt instruments.What is the solution ?

    Reply
    • Dear Santosh,
      Use FDs and RDs if your requirement is less than 3 years. For other goals, use EPF, PPF, SSY and Overnight or Liquid Funds.

      Reply
      • Thanks Sir,
        I feel for long term safe and better investment , EPF is the best among all others like PPF and SSY, etc. As you told , for short term, bank FD or RD is best for 1-3 yrs.
        I feel EPF ( voluntary contribution) is best for long term , even better than Debt mutual funds if you consider tax aspect.
        One can even withdraw partially for marriage, education, home purchase etc.

        So why to go for debt mutual fund ?

        Regards,
        -Santosh

        Reply
        • Dear Santosh,
          Use EPF for your retirement goals, PPF for goals which are more than 15 years away and Bank FDs or RDs for the goals which are less than 3 years.

          Reply

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